The Funds Flow Statement attempts to match the source of in-flow and the resulting outflow of funds in a specific accounting duration and helps analyze how the flow affects the firm’s working capital.
It is an essential tool that helps analyze the funds used. With the use of the fund flow statement, lenders or investors can validate the fund flowing through any firm in the coming future.
The fund flow statement indicates the motion of funds and their several applications and sources. It is also called the Application of Funds and Source Statement.
Generally, fund flow statements are created after the fund flow analysis. It caters to the firm’s financial parameter that assists in controlling its finances and forming a better plan to utilize its funds.
Funds Flow Statement analysis or fund flow analysis is the difference in the various components of a balance sheet. While evaluating a fund flow statement, it is also necessary to know all the aspects of a balance sheet.
When there’s an increase in the asset side of a balance sheet, it suggests that the company has purchased assets by investing funds. These assets will, in turn, generate an inflow of funds.
Following are some components :
And, if the assets show a decline, it reflects that the company has laid off some of its assets to generate fund inflow.
In the Funds Flow Statement, an increase in liability indicates that the organization has funds inflow to be paid in the future. Some components are:
A decline in liabilities means that the current dues have been satisfied.
A Funds Flow Statement is prepared in the following three ways:
According to the working capital calculation: Working capital = Current assets – Current liabilities
The above statement emphasizes the implications that change the working capital. Here are some reasons for a change in the company’s working capital.
In this step, the statement carries solely the funds flow from operating activities. The current year’s profit and loss are found, considering the depreciation or accounting for the loss on the sale of fixed assets. Following this, the previous year’s profit or loss is deducted from the latest calculations to derive the value of funds from operations.
This is the last step to determine the flow of funds. Thus, the answers to the previous calculations will be considered to understand the use of funds.
Companies have longer-term funds in non-current assets, such as patents, various investments in different companies, plants and types of machinery, intellectual property rights, equipment, buildings, etc. Thus, non-current assets are formulated in a given year whose monetary valuation is not thoroughly utilized in the accounting and financial year.
This factor gives rise to two situations:
So, the fund flow analysis highlights the modifications and applications of working capital; it can be long or short-term funds or their usage and can indicate its financial well-being. It is widely used to know the effect of the difference in a fund’s position and its uses in the short period between two balance sheets through its proper understanding.
Capital lenders want to understand the company’s financial standing before putting money in it. The funds flow statement is a significant scope of interest as it utilizes funds instead of focusing only on the operating profits or losses mentioned in a company’s financial statements. The best example of this is banks that use the funds’ flow statement to verify the overdraft status of the company and other cash credit inflow facilities.
A statement of funds flow of any business is a crucial financial tool to spectate and regulate working capital. Below are a few uses of Funds Flow Statement that financial analysts and funds managers opt for.
Although all financial statements report the resources and their utilization, they do not reflect the reasons for any changes in the balance sheet. The statement, thus, provides an analytical view of the variations between current assets and current liabilities. Moreover, it explains how the variations occur in the first place in the funds of a concerned company. Even when the company has earned a profit, it might face a cash shortage in a few cases. This statement gives a clear picture of the gains made in such situations.
Sometimes a firm has enough available profits to be distributed as a dividend to its shareholders but finds it difficult to do it due to insufficient liquidity. A Funds Flow Statement then helps identify liquidity errors and helps plan an effective dividend policy.
This statement also acts as a financial guide for any company. It brings out the financial arrears that a specific company could face in its future. The management can then plan an appropriate strategy to safeguard the company from significant future losses.
Institutions lending capital often evaluate this statement for a chain of years to analyze a prospective company’s creditworthiness before approving a loan. Hence, it also displays the firm’s competence in fund management.
Case 1: Increase in working capital
This situation kicks in when current assets increase the capital of a business. It can be stated as increased receivables or other assets or a decrease in current liabilities, leading to this situation. It shows that the company can now utilize the funds to align with its working capital needs, pay dividends, pay off some of its outstanding short-term obligations, etc., from a long-term standpoint. It is financially strong and a good prospect for its capital investors.
Case 2: Decrease in working capital:
This is when a company has minor long-term sources and more fund application points. Such a company needs to raise a loan to match its needs. Investors look to invest in the working capital needs of such a profitable company. The company that gets such working capital funding can reduce the stress of funds required for its working capital and use it to create long-term assets.
Due to this, the fund flow statement has many advantages. Other than pinpointing a company’s health, it also depicts the working capital reductions to create funds that can be utilized for long-term commitments and how different assets can drastically change the source of funds by using it judiciously.
Proper understanding of the company’s funds flow statement, and investor feedback is critical, as it depicts changes in sources of capital and fund usage for different purposes. Therefore, the excess/deficit in a firm’s current liabilities and assets is effectively shown only in the funds flow statement and not the P&L Statement or Balance Sheet.
From our above discussion, we can easily list down the benefits of a fund flow statement as:
Some Funds Flow Statement problems have limitations to its use.
Nonetheless, even with its limitations, this statement helps a financial analyst evaluate the financial statements and give inferences to use funds effectively. Thus, all small or big firms must be aware of their fund movements to make improved financial decisions.
The parts of a Funds Flow Statement are the sources of funds from outside and the capital brought in by its owners, and information on how these funds are utilized, whether they have been used on Fixed Assets or in Current Assets.
Working Capital Ratio is the ratio of Current Assets to the Current Liabilities.
If the working capital ratio is more than 1, meaning it is positive, and the company has enough cash to pay its short-term debts. If it is lesser than one or negative, the company faces problems paying its obligations in the short term and needs extra working capital.
The high working capital ratio depicts that the company has high inventory levels in assets and can face issues selling its products or transforming the inventory into Accounts Receivable in the balance sheet. It also indicates that the working capital is enough and must be appropriately used to invest in other business aspects such as paying off debts and other obligations.
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